Foreign ETFs – The Whole is Not Always the Sum of Its Parts

Nov 26, 2006 by

When you buy an exchange traded fund (ETF), its holdings are always disclosed. For instance, if I wanted to create a “consumer microprocessor ETF,” I might include

  • 50% Intel (INTC)
  • 50% Advanced Micro Devices (AMD)

To do this, I would buy $10,000 worth of Intel (at $21.59/share, that would be 463 shares) and $10,000 worth of AMD (at $21.80/share, that would be 459 shares). I would take the 463 shares of Intel and 459 shares of AMD, put them in a pot, and then release, say 1,000 shares of my own, new ETF, at $10 per share. Each share of this new ETF would be essentially a proxy for owning .463 shares of Intel and .459 shares of AMD. Thus, if the next day, the price of Intel doubled, the price of the ETF would nearly instantly rise to $15/share to reflect that owning .463 shares of Intel is now worth $10 instead of $5. Since the ETF is traded in the U.S., and Intel is traded in the U.S., the share price of the ETF moves at the same time as the share price of Intel. The price of the ETF remains in sync with its underlying assets, as the market corrects for any premium or discount that may surface in its price.

 Now, imagine that the U.S.-traded ETF instead contained shares of Samsung (a Korean company) and Tata (an Indian company). Needless to say, the markets are closed in India and Korea when they are open in the United States. Nonetheless, prices of this ETF and other foreign stock holding ETFs change throughout the day. What does this mean? Over the course of a day, the price of a share of a foreign ETF diverges from the closing price of its underlying assets. If in the middle of the American trading day, there is news that is bad for Tata, that will be reflected in the price of the ETF, although it cannot be reflected in the price of Tata, as the Indian market is closed. Hence, a divergence occurs.

1 Comment

  1. Steve Duvall

    The divergence between the underlying foreign stocks and the US traded ETF is a good example of why it is not a good idea to attempt to time a foreign market through the use of ETF’s. using the example of Tata and the bad news. If the market reacts to the news on expectation of Tata dropping substantially by driving the price of the ETF down. There is a possibility that two events will change the nature of this situation. One is that after the US markets close an update to the news indicates that the expected effect on Tata is different. Two the news stands; however, Tata’s share price doesn’t move as expected. The share price of the ETF has been driven down while the underlying shares were not affected. There is a very small chance that the share price of the ETF will be balanced the next open trading day in America. Over time this discrepancy will change in both directions. Therefore it is best to purchase an ETF as a lump sum or by dollar cost averaging.

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